Why the FHA Shouldn't Cut Its Mortgage Insurance Premium Again
Rumors have been circulating for the past few months that, in a grand parting gesture to aid homebuyers, the outgoing administration may again cut the mortgage insurance premium charged by the Federal Housing Administration (FHA). Based on our analysis of the previous premium cut, this would be a serious mistake.
Nonetheless, the administration may be tempted to act again. Since the election, the 30-year fixed mortgage rate has risen more than half a percentage point. The higher mortgage rate, combined with house prices that have continued to rise briskly in many markets, will crimp affordability for first-time buyers. In addition, FHA announced in November that the capital position of its insurance fund stood above the congressionally mandated minimum level for the second year in a row, allowing the administration to argue that it has ample financial room to address a worsening affordability problem.
A further reduction in FHA's annual mortgage insurance premium would follow the cut implemented in January 2015, which failed to live up to its billing despite FHA's assurances at the time that the "lower premiums [would] save more than two million FHA homeowners an average of $900 annually and spur 250,000 new homebuyers to purchase their first home over the next three years."
A reason for the failure is that FHA undertook the 2015 premium cut during a seller's market when too much demand was already chasing too little supply. The premium reduction, which provided borrowers with about 6 percent more buying power, only worsened this supply-demand imbalance.
Our analysis of the 2015 premium cut shows that prices for FHA-financed homes subsequently increased about 3 percentage points more than prices for homes with conventional financing, which were not affected by the policy change. This implies that FHA buyers actually saved only half of the 6 percent windfall from the premium cut.
The other half was spent in two ways: Part of it was capitalized into higher home prices as even more demand chased limited supply. We estimate that the median buyer with FHA financing paid around $1,300 more for the exact same house. In 2015, this resulted in a roughly $1 billion tax paid by all 800,000 FHA buyers. The rest was spent by going up-market, as FHA buyers purchased larger or more lavish homes or opted for more expensive neighborhoods.
Supporters of the FHA policy point to the additional 180,000 first-time buyers that FHA picked up in 2015 as proof that the premium cut worked as intended. However, our analysis shows that almost half of these buyers - attracted by FHA's lower monthly payments - were poached from other government agencies, mainly Fannie Mae or Freddie Mac. We also estimate that another third of the 180,000 buyers would have entered the market regardless of the lower premium, because an improving economy was raising incomes and lowering unemployment across the nation.
Only a sliver, around 35,000 buyers, were new entrants to the market who previously could not afford to buy a house. This figure is far short of the 83,000 new homebuyers per year (about a third of the 250,000 over three years) that FHA had promised.
Another premium cut to help borrowers offset worsening affordability would further boost house prices, adding more fuel to a market that has already seen house prices nationally rise faster than overall inflation and household income for several years. The last housing crisis taught us that, sooner or later, house prices will revert back to a sustainable trend. This correction - and the ensuing defaults by borrowers whose mortgages go underwater - will be all the more painful as the size of the home price run-up increases. Another premium cut would also only compound FHA's long-term funding challenge. To withstand such potential losses, FHA needs a well-capitalized insurance fund. But by lowering its premium, FHA will accumulate less capital over coming years, leaving it more vulnerable to a correction in house prices.
Instead of stimulating more demand for housing, the administration should have focused on the supply side of the market. The shortage of affordable housing can only be surmounted by removing burdensome zoning laws and regulations that are holding back the construction of economical homes and apartments. This is basic economics.
The seller's market that prevailed at the time of FHA's earlier premium cut continues today. There is little doubt that another premium cut will have the same consequences as the last one. It will drive up house prices and lead many buyers who would have purchased homes anyway to spend more on housing. At the same time, it will bring only a small number of new buyers into the market. The previous premium cut didn't work as planned, and one can only hope that the outgoing administration will refrain from going down this road again.